Cost

Cost Concepts

Introduction

• Cost of production changes with the change in output.

• The relations between cost and output is called as

Cost Function.

• The cost function depends upon• Production conditions• Prices of the factors of production• Level of output

• Whatever level of output a firm produces, it is produced at the minimum cost.

Concepts of Cost

The cost concepts can be grouped on the basis:• Nature • Purpose

Cost Concepts

Accounting Cost Analytical Cost

Concepts of Cost

1) Concepts used Accounting purpose The contractual cash payments which the firms makes to

the other factor owners for purchasing and hiring the other factors (Explicit cost).

2) Analytical Cost concepts- (for economic analysis of business )

Economic Cost = Accounting cost + Implicit Cost

Implicit cost is the normal return on capital invested by theentrepreneur and the wages or salary for his services and money rewards for the other factors which the entrepreneur himself owns and employs

Concepts of Cost

A firm will earn Economic profits only when its making revenue to excess of the total of accounting and implicit cost.

Economic profit = Total revenue – Economic cost

Accounting Cost Concepts

1. Actual cost ( Outlay or Acquisition cost:

The cost that the firm incurs while producing or acquiring a goods or services. ( cost of raw material, labour, rent…).

They are recorded in the book of accounts

2. Opportunity Cost:

The return of the second best use of the firm resources which the firm forgoes in order to avail of the return form the best use of the resources.

It is an example of implicit cost.

3. Sunk cost:

The cost which are not altered by change in quantity and cannot be recovered ( depreciation). They are part of outlay cost.

Accounting Cost Concepts

4. Business cost and Full cost

Business Cost includes all the expenses which are incurred to carry out a business.

Full Cost is equal to business cost plus opportunity cost and normal profit.

5. Explicit Cost and Implicit cost (Imputed):

Explicit Cost are those which are actually paid by the firm.

Implicit are theoretical cost and go unrecognised by the firm

Opportunity cost is a part of implicit cost

Analytical Cost Concept

1. Fixed Cost:

Cost which are fixed in volume and do not vary for a certain level of output

Cost of managerial and administrative staff, depreciation of machinery, building and fixed assets, maintenance of land

2. Variable Cost:

Vary with the variation of total output.

Cost of raw material, cost of direct labour, running expenses of fixed capital such as fuel, repairs , routine maintenance

Analytical Cost Concept

3. Total, Average and Marginal Cost :

Total Cost : Money value of the total resources required

for production of goods and services.

Average cost : TC / Q

Marginal Cost : Additional cost incurred when there is

addition to the existing output

MCn = TCn- TCn-1

Theory of Cost

Theory of Cost:

TC = f (Q)– Behaviour of cost in relation to change in output– Cost : Output relationship– The Total cost increases with the increase in output.– The direction of change in Average and Marginal Cost– Cost function depends upon the time framework chosen

for cost analysis:

1) Short – Run Cost Functions

2) Long – Run cost functions

Short – Run Cost Functions

• The short run cost is composed of

TC = TFC + TVC

– Total Fixed Cost (TFC)– Total Variable Cost (TVC)

Fixed Cost:

Cost which are incurred in hiring the fixed factors of production

whose amount cannot be altered in the short run.

Variable Cost:

Cost which are incurred on the employment of variable factors

of production whose amount can be altered in short run.

Short Run Table

Q TFC TVC TC (TFC+TVC)

0 50 0 50

1 50 20 70

2 50 35 85

3 50 60 110

4 50 100 150

5 50 145 195

6 50 190 240

7 50 237 287

8 50 284 334


Output

Cost

O

TFCB

TVC

TC

Q1

The shape :TFC : horizontal straight lineTVC: Rises upwards, increases at a decreasing rate uptoQ1, beyond which it increases at a increasing rate.TC: Same as TVC, the distance between them is constant because of TFC


AFC: TFC / Q It falls steadily as output increases. It slopes downwards,

as with increase in output TFC spreads over more units, as output becomes large, AFC approaches zero.

AVC: TVC / Q It falls with increase in output (increasing return), but

beyond a normal capacity output, AVC will rise steeply – diminishing returns.

ATC: TC / QATC curve depends upon the behaviour of AFC and AVC. Beginning both AVC and AFC falls so ATC also falls.AVC curve starts rising, but AFC falls, so ATC also fallsWith the increase in output, a sharp rise in AVC leads to rise of ATC.

Shape of SRTC curve

AFC

ATC

MC

AVC

Output

Cost

Shape of SRTC curve

• The shape of AC curve depend upon AVC and AFC• In the beginning both AFC and AVC falls, so AC falls• AVC rising and AFC falling, AC still falls• But as output increases, a sharp rise AVC offset the fall

of AFC and AC start to rise


Marginal Cost MC

MC < AC = AC falls ( MC pulls the AC down)

MC > AC = AC rises ( MC pulls the AC up)

MC AC

Relationship Between MC and MP of Variable Factor

Marginal Cost MC = ∆TC / ∆Q

In the short run, MC is independent of the fixed cost and depends upon the variable factors.

MP

AP

MC AVC

Q1 Q2

Relationship Between MC and MP of Variable Factor

• The behaviour of Marginal Product (MP) determines the shape of MC.

• The MC is an inverse of MP, with maximum of MP corresponding to minimum of MC.

• MC is the transformation of MP from physical term to money term.

Long – Run Cost Functions

• A firm can vary all its input

• The entrepreneur has before him number of alternative plant sizes and levels of output.

• In short run the size of the plant ( capital equipment, machinery, land…) are fixed.

• In long run the firm can move from one plant to another plant

• The LRAC is the least possible average cost production of producing any given level of output when all the inputs are

variable.

Derivation of Long Run Average Cost Curve

A B C D

K

L

H

G RJ

SAC1 SAC2 SAC3

Average cost

Output

• In long run firm can vary all its input.• The firm moves from one plant to larger plant if it has to

increase its output.• The long run average cost of production is the least

possible average cost of producing any given level of output when all the inputs are variable.

• The short run average cost curves are called as Plant curves.

• Suppose there are only three technically possible size of plant.

• The firm can choose among the three possible sizes of plant

• Upto OB amount of output, the firm will operate on the SAC1, though it could produce on SAC2.

• For OA output . It will cost AL per unit cost on SAC1 curve but it will cost AH if on SAC2. (AL < AH).

• If the firm plans to produce larger output than OB then it has to move to a bigger plant size.

• Thus OC if produced on SAC2 cost CK per unit which is lower than CJ when produced on SAC1.

• If the firm produce output between OB and OD it will employ the plant corresponding to SAC2.

Long-Run Cost Curve

G

Q

AC

M

LAC

N

K

F

Output

V


• The LAC is the locus of all the tangency points with the short run average cost curve.

• The long curve is also called as Envelope curve.

• LAC is not tangent to the minimum point of SAC.

• LRAC is called the planning curve: as the firm plans to produce any output in the long run by choosing a plant on the LRAC corresponding to the given output.

• Point G lies on the falling portion of SAC2, the firm is using the given plant below its full capacity. Point F is the minimum point

Why LAC is of U- Shape

• Why does LAC fall in the beginning: Economies of Scale

- Use of technically efficient Machines

- Division of Labour

- Indivisibility of factors

- Productive capacity of capital equipments rises faster then purchase price

- Discounts from bulk purchases

- Lower cost of raising funds

- Inventory management

• Why does LAC rise eventually: Diseconomies of scale

- Rise in transportation cost

- Input market imperfection

- Management co-ordination and control problems

- Depletion of raw material

Why LAC is of U- Shape

LRTC

IRTC

CRTC

DRTC

Output

LRAC

IRTC CRTC DRTC

The Concept of Optimum Firm

• The best or the ideal size of the firm

• The optimum firm is the one which operates on the scale at which, in the existing condition of techniques and organising ability has the lowest average cost of production.

• The optimum size of the firm varies a great deal in different industries.– In some industries the minimum point of the long run

average cost curve reaches at a comparatively small output ( agriculture, wholesale, retail…)

– Optimum size in steel, automobile, heavy industries is very large and the minimum point is reached at a very large output.

The Concept of Optimum Firm

Output

LAC

Output

AC

LAC

LAC as a Decision making Tool

• Which plant size to use?

The potential for using a plant of greater capacity is considerable

- Lowers the AC and MC

But it depends upon the actual forecast of potential demand

As the forecast helps in estimating the production capacity

Incurrence of unnecessary cost by producing at another

plant size

Co-ordination between Production plans and marketing forecast


Capacity Level

TP LRTC MC LRAC

A 10,000 50,000 5 5

B 20,000 90,000 4 4

C 30,000 120,000 3 4

D 40,000 150,000 3 3.75

E 50,000 200,000 5 4

F 60,000 2,60,000 6 4.33

The Learning Curve

• It is line showing the relationship between labour cost and additional unit of output.

• It’s a downward slope indicates that additional cost per unit declines as the level of output increases because workers improve with practice.

• Learning is the cumulative through time and enhances the efficiency, accuracy and productivity.

• The more the organisation learns

greater will be productivity.

Output

CostPer unit

The Learning Curve

• Reasons for fall in average cost:

– Job familiarisation and reduced time to instruct– Improved operating processes, machine speeds

and feeds– Improvements in machine and tooling– Larger manufacturing lots and reducing set up

time– Better co-ordination and managerial control

Thus learning curve describes the reduction in cost

per unit of Output as a firms cumulative output over

successive time periods increases, while output per

period may remain the same.

Economies of Scope

Cost effective for a single firm to produce more than one product than for separate firms to produce an equal quantity of output of the same product.

1) In case of a firm produces several products: common production facilities and inputs

2) Production of one good results in by-products that can also be sold by producers.

Economies of Scope

Degree of economies of scope =

TC (Q1) + TC (Q2) – TC (Q1 + Q2)

TC (Q1 + Q2)

TC (Q1) = Total cost of production Q1 units of good 1

TC (Q2) = Total cost of production Q2 units of good 2

TC (Q1 + Q2) = Total cost of producing goods 1 and 2 jointly

• If Degree of Economies of Scope

– Positive: Economies of Scope exist. Producing goods jointly is cheaper

– Negative: Producing goods separately is cheaper

Case Study – Natasha Computers

• Problem of Decision making– To drop Advanced computers from product line in favour

of old computers with new methods of production.

• Scenario: Recession in U.S, Global recession in the computer Industry

Natasha thinks that in order to remain in the competitive business, the company should adopt new technology in the production of traditional models, while advanced computers which have a narrow market at the top, would be most hard- hi during recession.

CEO thinks that the best strategy would, therefore be to produce traditional computers with old as well as new method of production


The Pre- recession stage

Fixed cost of Production: Rs 60,00,000

Volume of production: 20,000

Type of Computers

Price per Unit ( Rs)

Variable cost

Per unit

Proportion

in TP

Traditional 40,000 25,000 50

Advanced 75,000 45,000 50


The Recession stageFixed cost of Production: Rs 6,00,000Volume of production: 20,000 (Forecasted)

Type of Computers Price per Unit ( Rs)

Variable cost

Per unit

Proportion

in TP

Traditional by old method

40,000 25,000 60

Traditional by new methods of production

70,000 50,000 40

The logic of producing new and old computers by traditional method is thatOld is targeted towards mass market which is very price sensitive, New are quality conscious but within a reasonable price range.

Education

Cost